List of Arcticles

Monday, 30 January 2017

Risk Control Rectangle

In
this article, I would like to talk about risk management over the
course of trading. Amateur investors tend to put most of their
attention on how to invest to maximise their profits. There is nothing
wrong about this, the point of investment is to make profit after all.
However professional investors will consider seriously about risk
management before the investment and during the investment.

What is
the top priority of investment? To make money! One would naturally say.
The truth is that the top priority of investment is to protect most of
your capital intact during your investment process. The result of
investment can only be two: profit or loss. You just need to be sure
when loss happen, you don’t lose all or most of your money, such that
you can still have the capital to continue to invest and hopefully make
profit at the end. This is what a risk management system does.

If we
consider investment as a battle, and chasing for profit is the offence
aspect of a battle, then risk management is the defence aspect of the
battle. If we fight long term battles, a pure offensive strategy will
not last us very long while a good mix of offence and defence will keep
us going and wining.

There are two risk controls in risk management

Credit risk control

Profit/Loss control

Credit risk control

Credit risk control is about choosing how much from your money pool to
invest. It is the risk control before the investment.

There
is a saying about stock market investment: “10% of investors making
money, 20% of investors just breaking even, and the remaining 70% of
investors losing money”. I am not sure whether this figure is accurate
but I guess over 50% of the investors losing money in stock market
probably not an under estimation. Here comes the question, why is that?

Before
jump into conclusion, let me take an example. Say Joe has $1000 to
invest, and he invests into a stock that has 50% of going up and 50% of
going down. Joe is not a total amateur investor and he has strict
win/loss control. Whenever the stock goes up 20% or goes down 20%, he
will close the position and stop win/loss. And he chooses to only
invest twice.

Then Joe wasn’t extremely luck and didn’t win on both
investments, and he wasn’t extremely unlucky and didn’t lose on both
investments. He ended up one won and one lost. With that, there are two
possibilities:

Joe won on the first, and lost on the second. His
capital after first investment = 1000 + 1000 x 20% = 1200; His capital
after second investment = 1200 – 1000 x 20% = 1000

Joe lost on the
first, and won on the second. His capital after first investment = 1000
- 1000 x 20% = 800; His capital after second investment = 800 + 800 *
20% = 960

What is happening there in scenario 2)? He won and lost
exactly once, we would expect the capital is back to 1000 but why it is
not? This is because after the first lost, Joe’s capital is down to
800, even he won 20% in the second investment, it's the 20% of 800 gain
versus 20% of 1000 lost in the first investment.

The lost hurt more
than the cure of won. This is always true in the
investment world and
some serious lost can make investor forever lost the opportunity of
seeing the future win. This is where credit control comes in. You
should always control how much you invest, do not dump all your cash in
one go. In Joe’s example, if he had chosen to invest only $800 and not
all his $1000 cash, he would have ended up even after a lost and a win.

Credit
risk control is to calculate the potential risk of loss and choose a
reasonable proportion of your cash out from your capital to invest to
avoid run into credit risk.

Profit/Loss control

Nowadays, most of
people know or have heard about stop loss or loss control. This is when
you have picked a wrong investment; you decide to take a reasonable
loss to exit and avoid possible greater future loss. The concept is
straight forward.

Why do we need to control the profit? Isn’t that
the bigger the better? Well the reason behind it is similar to why we
need to control loss:

We predict the price will go down when we have a long
position or the price will go up if we have a short position

Through historical data study we learn that the stock has
reach the peak and most likely will go the other way

We need to lock in our profit.

As
part of profit/risk control, we also have the time control. This is
best to illustrate in the following diagram, which I call it the Risk
Control Rectangle.

The following graph is a FX price chart taken for
USDJPY. I have put a rectangle on a segment of the chart. As you can
see each edge of the rectangle is drawn with different colors. I will
explain the meaning of each edge and how they work together to form a
strict risk control frame. For the purpose of easier to explain, I will
assume we take long position in this example.

Blue edge
– This is
when we get into a position. The intersection of blue edge and the
price line is the position price. When a position is taken, we have
invested into something, opening up the opportunity of profit, as well
as loss.

Red edge
– This is where the stop loss control is. When the
market price drops below this line, we will need to exit the position
and cut loss. Depending on our trading strategy, this line can be fixed
or can be dynamically changed over time, e.g. trailing stop loss
control.

Green edge
– This is where stop win control is. When stock
price has gone up this line, we exit our position and lock down the
profit. Again subject to trading strategy, this line can be fixed or
can be dynamically changed over time.

Black edge
– This when we
consider our invest period is end and when we need to exit the position
just because time runs out. The end time control is especially
important for day trading strategy – at least we need to exit all
positions before the market closed for day. It also makes sense for
quantitative trading. If our strategy is based on x period of data,
then our position held should be shorten then x period. Why is that?
Quantitative trading is a game of predict the future based on the pass.
It wouldn’t make sense if you study 3 days data and try to predict what
will happen over 4 days, would it?

Conclusion

Through the risk
control rectangle, we firmly control our profit/loss within a price
range and time series range. Although the risk control rectangle itself
doesn’t guarantee us the profit, it does protect our capital from
serious loss in a single investment. This is extremely important for
automated trading strategy since you won’t have a trader to watch the
market for you.